Carbon markets emerge when market-based instruments take hold and trading of carbon emission certificates begins. Market-based instruments put a price on emissions of climate-damaging greenhouse gases, thus promoting efficient climate change mitigation. There are basically two different approaches which lead to the creation of carbon markets: emissions trading schemes and crediting mechanisms.
An emissions trading scheme (cap-and-trade system) sets a regulatory ceiling or ‘cap’ on greenhouse gas emissions being regulated under the scheme. Within the sectors covered by the scheme, only a limited quantity of emission permits (allowances) are issued, namely just enough to allow the reduction target to be met. Each business covered by the emissions trading scheme must possess an allowance for each tonne of CO2e they emit. These allowances can also be freely traded. This allows participants in the scheme to buy additional allowances or, if they have succeeded in reducing their own emissions, to sell excess allowances they no longer need. This gives rise to a uniform carbon price, which in turn serves as an important market signal. The price depends largely on the level of ambition applied when setting the upper ceiling of the emissions trading scheme and on the costs incurred in implementing the emission reduction measures.
Emissions trading schemes can be introduced at various levels (international, national, subnational) and, depending on their design, can cover either businesses or governments. The EU Emissions Trading Scheme (EU ETS) is a fitting example of a regional emissions trading scheme which regulates emissions from companies. Under the Kyoto Protocol, an international emissions trading scheme was created in which national governments participated in certificates trading: the Protocol sets both a common emissions ceiling along with individual targets for Annex B countries and enables direct trading between them.
A crediting mechanism (a baseline and credit system) enables remuneration of achieved emission reductions. With this type of mechanism, tradable certificates are issued for actual emission reductions achieved. Certificates are issued when actual emissions are verifiably reduced below a predetermined baseline. A crediting mechanism can either be based on individual climate change mitigation projects and programmes, or be designed to cover entire industries or industry sectors.
Participation in a crediting mechanism is voluntary and demand for generated certificates must thus be created elsewhere. This can be done, for example, by allowing the certificates generated under the crediting mechanism to be traded in an emissions trading scheme. The Clean Development Mechanism (CDM) – a crediting mechanism operated under the Kyoto Protocol – is one example of a crediting mechanism where the certificates it generates can be used in an emissions trading scheme. Certificates generated from climate change projects conducted under the CDM can be used by companies covered by the EU Emissions Trading Scheme to comply with their climate change mitigation obligations. Another source of demand for emission reduction certificates comes from what is known as the voluntary market. This newer market enables businesses and individuals to use crediting mechanisms to reduce their carbon footprint voluntarily.